Implicitly Too Big To Fail

Senator Richard Shelby yesterday provided a letter to Treasure Secretary Timothy Geithner listing his complaints related to the financial reform bill that was approved by the Senate Banking Committee on Monday.   The Banking Committee bill includes a provision requiring large financial companies to pay into a $50 billion fund to be used for dismantling a failing company deemed critical to the market (see, e.g., AIG). Senator Shelby complains that the market would view the firms required to pay into the fund as (1) having been designated “too big to fail” by the federal government and (2) “implicitly backed by the government.” 
 
As for the first part, I agree with Senator Shelby.  It’s hard to argue that the list of companies required to pay into the fund wouldn’t be deemed companies the government views as critical to the market, even if there were no guarantee the government would actually use the fund if the company failed. 
 
For the second part, he is probably right, too, but it shouldn’t matter.  I have never been fond of “implied guarantees,” either in this context or in the context of government-related entities such as Fannie Mae and Freddie Mac.  (For good, and somewhat competing, overviews, see this article, by Richard Scott Carnell, and this one, by David Reiss.)

At least in the world of high finance, I just don’t like the concept of implied or implicit guarantees at all. If you are savvy and sophisticated and you want a guarantee, get one – the explicit kind.  If not, there isn't one.  Otherwise, the guarantee is simply a hope – a calculated risk – that someone will step in and conduct a bailout if it is needed 
 
This is not unlike a local shop granting a 22-year-old child of wealthy parents a line of credit. The shop knows who the child is and knows who his parents are, and figures it’s worth the risk because the parent will likely cover any outstanding charges. The parent may choose, and perhaps is likely to choose, to pay the bill to protect the reputation of the child, the family, or both.  However, unless the parent has agreed to be obligated to cover the bill, the shop always runs the risk that the parents will decide it is no longer worth it.
 
This holds true on the large scale, too.  The debate shouldn’t be about whether the government has made implicit guarantees, and, in fact, the bill should explicitly state the government is not making any guarantees.  Absent explicit guarantees, the debate needs to be about whether the government should step in, not whether it must. 

-- Josh Fershee